A budget balancing various considerations - Hong Kong 2021-22 Budget insights

Proposed tax concessions for eligible carried interest received by private equity fund managers

In today’s Budget the Financial Secretary (FS) noted that over the past few years the Government has spared no efforts in developing Hong Kong as a premier private equity (PE) fund hub. These efforts have included the introduction of a new limited partnership law effective from 31 August 2020 that specifically caters to the operational needs of PE funds. Thus far, about 100 limited partnership funds (LPFs) have been set up in Hong Kong under the new law¹. Furthermore, a unified fund exemption regime (UFR) has been introduced since 1 April 2019. Under the UFR, funds in the form of a collective investment scheme, regardless of their residence, size or type, are exempt from profits tax in Hong Kong in respect of their usual investment and securities trading income.

To further incentivize PE fund managers to choose Hong Kong as the location of domicile and operation of funds under their management, the FS noted that a legislative bill (the Bill) was introduced earlier this month. Under the Bill, management fee income in the form of eligible carried interest received by a PE fund manager will not be charged to profits tax (i.e., the income will be taxed at the rate of 0%); and 100% of the eligible carried interest received by an employee, who renders the relevant services to the PE funds on behalf of their employer, will be excluded from their employment income in the calculation of salaries tax.

Subject to the passage of the Bill by the Legislative Council, the above concessionary tax treatment will be effective retrospectively and will apply to eligible carried interest received by or accrued to a qualifying recipient on or after 1 April 2020. 

Nonetheless, a key requirement of the proposed concessionary tax treatment is that the profits of the PE funds themselves out of which carried interest is paid must, in the first place, be exempt from profits tax under the UFR. Currently, it is however unclear whether the relevant provisions of the Bill will be further refined or interpreted in a manner that will extend the proposed concessionary tax treatment to cover carried interest paid out of the offshore sourced profits of a PE fund, i.e., where such profits are technically not exempt under the UFR but are simply outside the scope of charge of profits tax in Hong Kong.

Expanding the investment scope of special purpose entities owned by a fund

At present, where a fund employs a special purpose entity (SPE) to hold directly or indirectly its investments in private companies, the sole activities of said SPE will be limited to administering and holding the investee private companies. Otherwise, the SPE’s direct or indirect disposal of the investee private companies, would not be exempt from tax in Hong Kong.

In order to give flexibility to the operational needs of funds, the Bill also proposes that a fund will in future be allowed to employ an SPE to hold its investments, not only in private companies, but also other common types of investment such as listed securities and derivative contracts that belong to any other classes of assets as specified in Schedule 16C to the Inland Revenue Ordinance (IRO). 

We welcome the Government’s introduction of the Bill which will boost the development of the PE fund industry in Hong Kong. 

Facilitating foreign investment funds to set up or re-domicile to Hong Kong as OFCs or LPFs 

In view of the latest regulatory developments in traditional foreign fund jurisdictions which are rendering it increasingly costly to set up and maintain offshore funds in those jurisdictions, the Government considers that more offshore funds, could be attracted to move their domicile to Hong Kong, where their substantial business activities can be conducted. 

In this regard, the FS indicated that a legislative proposal will be submitted in the second quarter of this year to allow foreign investment funds to re-domicile to Hong Kong for registration as OFCs or LPFs.

In brief, the objective is to create a commercially viable and facilitating mechanism with legal and tax certainty for foreign funds to re-locate to Hong Kong and ensure that the re-domiciliation process would not give rise to any stamp duty implications.

In addition, the FS proposed that the Government will provide subsidies to cover 70% of the expenses paid to local professional service providers for OFCs set up in or re-domiciled to Hong Kong in the coming three years, subject to a cap of HK$1 million per OFC.

We welcome the introduction of the above proposals to further enhance the competitiveness of Hong Kong as an international asset and wealth management hub.

Family office business has flourished in recent years and become an important growth segment in the wealth and asset management industry. 

However, Hong Kong’s existing tax exemption regimes for funds, albeit generally attractive, may not apply to certain family offices. As such, some market participants have proposed amending the relevant provisions of the IRO such that more family offices can enjoy tax exemption in Hong Kong. One such proposal is that:

• Family offices that satisfy certain conditions e.g., a specified amount of assets under management in Hong Kong, would be exempt from tax in Hong Kong in respect of their investment income. 
• Such tax-exempt income of the family offices would not be deemed to be received by their Hong Kong resident shareholders and, therefore, would not be taxed in Hong Kong in the hands of such shareholders under the existing deeming provisions for tax-exempt funds in Hong Kong.   

In this regard, the FS simply indicated that he would review the relevant tax arrangements, without explicitly referring to any of the above proposals. We hope that the FS can complete his review at the earliest possible time, given that other wealth and asset management centers in the region are increasingly targeting their tax incentives at family offices. 

Today the FS reported that the Government had last month successfully offered its green bonds totaling US$2.5 billion to investors under the HKSAR Government Green Bond Program, an amount more than double the size of its first green bond issuance in 2019². 

The 30-year green bonds were the longest tenor of bonds issued by the Government and also the first such green bonds issued by an Asian government.

To encourage the private sector to issue more green bonds, in June 2018 the Government launched a three-year Green Bond Grant Scheme. 

Under the Scheme, the Government will fully subsidize issuers in respect of costs they incur in obtaining certification under the Green Finance Certification Scheme for their qualifying green bond issuance.   

In addition to extending the Scheme upon its expiry in June 2021, the FS may also consider introducing tax measures to further incentivize the issuance of, and investment in, green bonds in Hong Kong.

In this regard, the FS may consider allowing a super tax deduction of 200% for qualifying expenditure with respect to the issuance, and compliance costs related to the issuance, of qualifying green bonds (QGBs). This would offset the additional costs that issuers need to incur in issuing green bonds, such as costs incurred to obtain third party verification and compliance with regular reporting requirements after issuance. To attract more investors to invest in QGBs trading in Hong Kong, the FS may also consider extending the scope of the tax exemption under the existing Qualifying Debt Instrument scheme to include all QGBs. 

We hope that the FS will give further thought to the above proposed tax measures when he reviews and formulates policy measures in relation to green bonds.

The demand for insurance and reinsurance businesses for specialty risks (e.g., marine, aviation, agriculture, catastrophe, political risk, war risk and trade credit) is expected to increase significantly under the Belt and Road Initiative. 

To enable Hong Kong to compete in the international insurance market and seize new opportunities, the FS noted in today’s Budget that a series of legislative work is being undertaken. Included in such legislative work is a new law, effective next month, that grants the following tax concessions to relevant insurers and insurance brokers: 

1. Profits derived by a direct insurer (referred to as a specified insurer) from their general insurance business, other than profits from certain local-demand driven business, will be taxed at the concessionary tax rate of 8.25% (i.e., 50% of the normal corporate tax rate of 16.5%)
2. The current 8.25% concessionary tax rate afforded to professional reinsurers will be extended to cover the general reinsurance business of a specified insurer
3. Profits of a licensed insurance broker company that relate to a contract of insurance effected by (a) a professional reinsurer; or (b) a specified insurer that is eligible for the concessionary tax rate under the bill, will also be taxed at the 8.25% concessionary tax rate

We welcome the introduction of the new law which will make Hong Kong more competitive vis-à-vis other major insurance hubs. 

What does this mean for Hong Kong?

In today’s Budget the FS indicated that the Government has already set up an Advisory Panel that includes scholars, tax experts and members of the business community to review the potential impact of BEPS 2.0 on Hong Kong’s business competitiveness and to provide recommendations to the Government. 

While the FS did not provide further details on how Hong Kong is going to respond to the challenges posed by BEPS 2.0, it is clear that the Government needs to safeguard its primary taxing rights and maintain the tax competitiveness of Hong Kong, whilst making utmost efforts to meet the required international tax standards.

Safeguarding Hong Kong’s primary taxing rights

Under the proposed GloBE rules, the low-tax income of overseas constituent entities of an in-scope Hong Kong ultimate parent entity (UPE) could be subject to an IIR in Hong Kong. If Hong Kong were to impose the IIR on such income, and thereby top-up the low-tax paid overseas by the overseas constituent entities such that the total tax paid reconciled to the required global minimum rate, this would preclude other overseas jurisdictions from applying the UTPR to achieve the same top-up effect. This approach would preserve Hong Kong’s primary taxing rights over the Hong Kong-UPE.

The Pillar Two Blueprint however indicates that the low-tax income of constituent entities located in Hong Kong of an in-scope Hong Kong-UPE cannot be subject to the IIR in Hong Kong. As such, absent an applicable IIR, the constituent entities located in Hong Kong would be subject to the UTPR of overseas jurisdictions in respect of certain payments received from related parties, i.e., the tax authorities of those overseas jurisdictions instead of Hong Kong would collect the top-up tax. 

Given the above, and as envisaged in and allowed by the Blueprint, one option may be for Hong Kong to consider introducing an alternative domestic minimum tax regime in respect of the low-tax income of the constituent entities in Hong Kong of an in-scope Hong Kong-UPE. Under such alternative minimum tax, the tax paid by the constituent entities in Hong Kong would be equal to an amount such that their effective tax rate would be equal to the required global minimum, thereby precluding the potential application of the UTPR by any overseas jurisdiction. 

Conceivably, such domestic minimum tax regime can also apply to the low-taxed income of the Hong Kong constituent entities of an in-scope, non-Hong Kong-UPE, resulting in Hong Kong rather than any overseas jurisdictions collecting the top-up tax. 

Enhancing the business infrastructure and competitiveness of Hong Kong post BEPS 2.0

It is generally expected that tax revenue collected by the Government will increase upon the implementation of Pillars One and Two. This however will also mean that Hong Kong with its territorial-sourced based regime, non-taxation of capital gains tax and many other preferential tax regimes will be less attractive to many in-scope MNE groups, given that they may have to pay the top-up tax under an alternative domestic minimum tax regime in Hong Kong or overseas. 

As such, in addition to maintaining the existing appealing features of Hong Kong’s profits tax regime, which should continue to be attractive to out-of-scope MNEs and in-scope MNEs (albeit to a lesser extent under Pillar Two), the Government may also need to consider exploring ways to ever further enhance Hong Kong’s business infrastructure and environment in order to compete for investment post BEPS 2.0.

Summary

This year's budget has struck a good balance and introduced measures that will help stimulate Hong Kong's economy and enhance its competitiveness.